Tax Efficiency: Asset Class And Process Trump Vehicle Type ( ETFs can be more tax-efficient than active mutual funds but are not necessarily more tax-efficient than well-run index mutual funds)

Michael Rawson, CFA writes: With so much uncertainty in financial markets, there are few outcomes over which investors have much control. One area in which informed decision-making can consistently pay off is with regard to tax planning. Investors in high tax brackets or with a lot of money to invest should consider which asset classes and which strategies are best held in a taxable account and which are best held in a tax-deferred account. Passive strategies generally are more tax-efficient, but this is not always the case, particularly if an index fund invests in an asset class with high tax costs or tracks an index with high turnover.

Asset Class Tax Treatment Trumps All Else
Certain asset classes offer better aftertax returns in tax-deferred accounts, such as assets that throw off a large share of their total return in the form of interest income, which is taxed at ordinary income tax rates. For example, if an investor in the highest tax bracket were to hold iShares Core Total U.S. Bond Market ETF (AGG) in a tax-deferred account, they would have earned a 5.78% annualized return for the five years ended Dec. 31. That same investment held in a taxable account would have returned only 4.43% for an investor in the highest tax bracket. When choosing a fund for a taxable account, one would have been better off with the iShares National AMT-Free Muni Bond ETF (MUB) which returned 5.48%. But in the tax-deferred account, the muni fund underperformed the taxable iShares Total U.S. Bond Market fund.

Investments that generate nonqualified dividends, such as REITs, are also better held in tax-sheltered accounts because those dividends are taxed at investors' ordinary income tax rates. For example, T. Rowe Price Real Estate's (TRREX) 10-year annualized return of 12.53% drops to 10.99% for an investor in the highest tax bracket, once taxes are factored in.

Qualified dividend income, on the other hand, is somewhat tax-advantaged compared with ordinary income. For 2013, the highest ordinary income tax rate is 43.4% when including the 3.8% Medicare tax surcharge on high earners, while the highest tax rate is 23.8% on qualified dividends. Over the long term, dividend-paying stocks have performed well, so risk-tolerant investors with additional money to invest can hold dividend-focused funds in taxable accounts, despite the slight tax disadvantage compared with holding them in a tax-deferred account. Naturally, you would put dividend-paying funds in a tax-deferred account first, but those with large taxable accounts should not necessarily avoid dividend-paying stocks. It is important to remember that it is the total aftertax return that is most important, not necessarily minimizing taxes. For example, while it is true that during the past five years, an investor in Vanguard Dividend Growth (VDIGX) paid more in taxes than an investor in a typical S&P 500 Index fund, VDIGX still had a much higher aftertax return.

Strategies Still Play a Role
Although the decision about which asset classes to hold in which account types are a crucial component of tax management, investors can also help improve their aftertax results by focusing on tax-efficient strategies for their taxable holdings. Exchange-traded funds are often touted as tax-efficient investments because they can gain an edge through the use of an additional tax-fighting weapon at their disposal: the creation and redemption process. Rather than selling stock to meet investor redemptions, ETFs are redeemed through an in-kind transfer with an authorized participant. The in-kind, or shares for shares, transfer allows for the elimination of low-cost-basis shares, thus reducing (but not eliminating) the possibility of future capital gains distributions.

But here is the rub: This in-kind creation and redemption mechanism works best for U.S.-stock funds. Once we venture outside of the U.S.-stock asset class, the tax benefits stemming from the in-kind creation and redemption process might diminish somewhat. In addition, investors will owe taxes on the distributions of dividends or interest income that the fund receives and will face capital gains taxes when selling the fund, regardless if the fund is an ETF or index mutual fund. ETF tax efficiency only relates to the likelihood that the fund itself will incur and distribute capital gains to its shareholders.

And even for U.S.-equity ETFs, most of their tax efficiency stems from the fact that they are index funds, which typically have low turnover and thus generate fewer capital gains than actively managed funds. There are plenty of ETFs (and conventional index funds, for that matter), that follow higher-turnover, so-called strategy indexes, which might be less tax-efficient than traditional, market-cap-weighted index mutual funds. For example, the PowerShares Fundamental Pure Large Core (PXLC) had a five-year tax-cost ratio of 0.63, high by equity ETF standards, likely because of the fact that the fund has high turnover.

In addition, a handful of tax-managed mutual funds--traditional open-end funds that hew closely to market benchmarks but have active oversight--have achieved tax efficiency by following best practices, such as limiting trading, keeping track of tax lots, and appropriately timing the sale of high-cost-basis shares. In summary, tax efficiency comes from diligent implementation of a sound low-turnover strategy, not necessarily from some magical tax loophole afforded only to ETFs.

Delving Into the Details
Let's look at some specific examples to illustrate the point that ETFs can be more tax-efficient than active mutual funds but are not necessarily more tax-efficient than well-run index mutual funds.

The iShares Core S&P 500 ETF ( IVV) had a 10-year pretax annualized return of 7.03% and a post-tax (but preliquidation) return of 6.71%. This results in a tax-cost ratio of 0.30. The tax-cost ratio measures the amount of return lost to taxes, so a lower number in combination with a higher after return is better. A similar ETF,
SPDR S&P 500 (SPY) had a 6.99% pretax return and 6.65% post-tax return, for a tax-cost ratio of 0.32. The average tax-cost ratio for actively managed large-blend funds during the past decade has been 0.60, so these two ETFs have been much more tax-efficient.

But a number of index mutual funds and tax-managed funds have also been tax-efficient. The institutional share class of Vanguard Institutional Index (VINIX) had a pretax return of 7.11% and 6.78% post-tax, for a tax-cost ratio of 0.31. The Vanguard index mutual fund was equally tax-efficient as the two ETFs. Yet not all index mutual funds are as well-run as Vanguard's. T. Rowe Price Equity Index 500 (PREIX) had pretax and aftertax returns of 6.83% and 6.11%, resulting in a tax-cost ratio of 0.67%.

Data sourced from iShares, PowerShares, T. Rowe Price, Vanguard, and Morningstar. Tax-cost ratio data reflect five- and 10-year periods ended Dec. 31, 2012.